Why do we allow investors to deduct stock market losses from their taxes?

This is just one of the stories in our “I’m Always Amazed” series, where we answer all your questions about the world of business, big or small. Have you ever wondered if recycling is worth it? Or how the store brands stand against name brands? Check out more from the series here.

---

Listener and reader John Wang from Eden Prairie, Minnesota asks:

Why are stock market losses tax deductible? It seems that we the people provide insurance or indirectly finance the risky bets of private investors.

We just went out Wall Street’s worst year since the Great Recession.

By the fall, American families had lost almost $9 trillion in wealth as stocks decline amid decades-high inflation and rising interest rates.

As investors enter tax season, they may be able to deduct some of their losses. But there are rules that govern the types of investment losses you can deduct and limit how much money you can write off.

Capital losses, and how they are treated, have actually been the subject of debate for more than a century, since the modern income tax system was put in place in 1913, according to to a report by the Congressional Research Service.

“Over the last 100 years, there has been a broad consensus that has developed that it would not be fair to tax capital gains without taking some consideration of capital losses,” said Janice Traflet, professor of accounting and financial management. at Bucknell University.

First, here’s how capital loss works

If you sell an investment, including stocks and bonds, for less than it cost you, that counts as one “capital loss”. A loss also has to be “realized,” which means you can’t deduct it from your taxes if your investment just went down in value. You really have to sell.

Capital gains and losses are divided into two categories based on time: short-term (meaning you held the asset for a year or less) or long-term (you held it for more than a year).

You can deduct the capital loss against capital gains, reducing your overall tax bill.

But the losses must first offset the gains in the same category. “Short-term losses offset short-term gains first, while long-term losses offset long-term gains first.” according to Bankrate. Any excess loss can then “offset gains in the other category.”

This matters because the tax rate on short-term capital gains (the same rate as your ordinary income tax bracket) is different from the long-term capital gains rate (either 0%, 15% or 20%, depending on your income or filing status). That’s at least in part because the government wants to encourage you to keep your investment, and discourages trading in-and-out of “hot stocks.” In fact, if you’re a married couple earning $83,350 or less in annual income and you file jointly, your long-term rate is a lucky 0%.

OK, so deduct your capital losses against your capital gains. But what if your losses exceed your gains? Or what if you didn’t have any capital gains in the first place?

You can then deduct $3,000 of your losses against your annual income, although the limit is $1,500 if you are married and file a separate tax return. If your capital loss is even greater than the $3,000 limit, you can claim additional losses in the future.

So, for example, if you have a net capital loss of $10,000 and you offset $3,000, that leaves you with $7,000 that you can carry over to offset future capital gains or income, Bucknell University’s Traflet explained.

Here’s why the United States allows you to deduct some of your losses

The rules governing the loss of capital they have existed in various iterations through the decades. Between 1913 and 1916, capital losses were deductible only if they were “associated with the taxpayer’s trade or business,” according to the Congressional Research Service report. From 1916 to 1918, losses were deductible against any capital gain, even if it wasn’t associated with your business.

The Revenue Act of 1918 then allowed “unlimited loss deductions“, a temporary move. From 1924 onward, “the tax law provided for the partial, not full, deductibility of capital losses,” Traflet said.

During the Great Depression, the distinction between short-term and long-term tax treatment and the notion of loss carryforwards were introduced, but “the partial deductibility of capital losses still reigned”, added Traflet. “No doubt, investors who incurred tremendous real losses in the Depression would have loved to have had a return to the brief era of full deductibility of their capital losses.”

Further changes continued to spread over the following decades.

Mihir Desai, a professor at Harvard Business School and Harvard Law School, also said that the deductions are implemented with the aim of treating taxpayers fairly.

“Every tax system tries to figure out what the ability to pay is for each person,” Desai said. “If you have more income, then you have more ability to pay, so you should be taxed more. A loss is similar. When you have a loss, you have less ability to pay. And so we think it should function as a deduction.”

Traflet and Desai said that our tax system actually restricts our ability to deduct losses. A “fair” argument that could be made for increasing the $3,000 limit, Desai said, is that this amount has remained the same for decades, failing to account for inflation.

Desai said that in theory, risk-taking gives people the opportunity to build businesses, which is “a source of growth for the economy.” The argument goes that “risk-taking is how capitalism works, so there’s no reason to penalize it,” Desai said. In this sense, allowing people to mitigate part of their investment losses through a tax deduction contributes to a healthy economy.

But, he said, there are some forms of risk that others find “ridiculous.”

“It is difficult to discriminate between different types of risks,” he said. “What seems like a foolish risk to me to take could be your dream.”

“Manufacturing losses” for the tax advantage

Because of the limits placed on capital loss deductions, Desai wanted to turn the issue on its head by asking, “Why don’t we just allow people to deduct all their investment losses?

“And the reason is because then we start to worry that people are using a lot of different devices to basically manufacture leaks,” he said.

There are “legitimate” and “problematic” ways investors can take advantage of tax-deductible losses, Desai said.

Under our current “achievement-based system” in which we are taxed on the share gains we receive, he said, you can wait to collect your gains to defer paying these taxes, but sell your losses right away so that you can deduce first. . “It’s kind of opportunistic,” even though it’s built into our system, he said.

But there are more “pernicious forms” of this, Desai said.

Here is an example of a scenario that the IRS struggled with before the Tax Reform Act of 1986. Desai said that if he got rich and made a lot of money, one way to manipulate the system was to become a partner in a firm what do you know you will lose money, allowing you to use these losses to offset your taxable income.

Investments intended to create losses for tax purposes are known as tax havens, according to a paper by economist Andrew Samwick.

“An otherwise high-income taxpayer could, with very little direct effort, use tax shelter losses to lower their average tax rate below that of a low-income taxpayer with no tax shelter losses,” Samwick wrote.

IRS rules stemming from the tax law of 1986 limit your ability to deduct losses if you have not “materially participate” in that business.

“But it’s really hard to police against this use of passive leaks,” Desai said. “That’s the other version of why we’re really worried about investment losses.”

The “wash-sale” rule is another attempt to combat manipulation. The Internal Revenue Service prohibits you from deducting losses on the sale of a security if you purchased that same security in 30 days before or after the sale.

So in general, the United States has a balanced system for the tax treatment of investment losses. It allows them to be deducted, but doesn’t “subsidize” them either, Desai said.

In other words, Uncle Sam feels your pain, but for the most part, you’re alone.